Yellen knows the cost of Fed failures

Commentary: There’s a cost to doing too little, as well as to doing too much

Janet Yellen has a tricky task ahead of her as Federal Reserve chairman: Getting the economy and Fed policy back to normal.

WASHINGTON (MarketWatch) — Newly minted Federal Reserve chairmen have faced some pretty tough economic challenges on their first day on the job: Marriner Eccles took over in the middle of the worst depression in our history, and Paul Volcker had to whip a terrible inflationary spiral.

By comparison, incoming Fed Chairwoman Janet Yellen has it pretty easy. She doesn’t have a catastrophic crisis that demands immediate action. At least, we hope there won’t be one between now and Feb. 1 when she’ll take the oath as the 15th head of the Fed.

That doesn’t mean she has it good, however. In some ways, her task may be even trickier, because she has to manage the exit. She has to bring Fed policy — and the economy — back to normal.

In a crisis, it may not be obvious what the right thing to do is, but almost everyone agrees that something must be done. In Yellen’s current situation, however, there’s not only very little agreement about what should be done, there’s significant opposition to the Fed doing anything at all.

After five years of zero-interest-rate policy and trillions of dollars of asset purchases that have expanded the Fed’s balance sheet beyond imagination, fatigue has set in.

Many people would like the Fed to stop buying bonds and just raise interest rates already. They say all that money is bound to fuel inflation, someday. If printing money were going to repair the economy, it would have worked by now, the thinking goes.

Some fear that some markets have gotten addicted to the cheap money, and that the Fed should burst the bubble now rather than let it get any bigger.

At the heart of these criticisms is the argument that the Fed is ignoring the potential costs of its accommodative policies, just as Alan Greenspan’s Fed ignored the costs of its low interest rates and lax supervision of the financial system a decade ago.

Once upon a time, the Fed would have responded to such criticisms with a condescending pat on the head and a reassurance that the Fed knows best. After the financial crisis, however, such hubris is untenable.

Today’s Fed can’t promise us that the worst could never happen. That’s what they promised in 2008, and the worst very nearly happened.

Today’s Fed takes its “tail risks” seriously. It is monitoring the financial system from every possible angle to spot trends early. They may not get it right, but it won’t be because they are asleep on the job. So far, there are no signs of bubbles or incipient inflationary pressures.

The Fed is also taking the other end of the tail risk seriously, the risk that the Fed hasn’t done enough.

The evidence is mounting that the economy has suffered permanent damage from this depression, that the nation’s long-run economic potential has been reduced, that our children and grandchildren will pay for this.

Many critics of central bank intervention during economic downturns say that the long run will take care of itself if we just let the crisis play out. This was Andrew Mellon’s view in the early 1930s: Liquidate everything. It’s the view of people today who say that a debt crisis cannot be solved by more debt.

But they are wrong. It’s not just that millions of lives are being squandered while we wait for the long run to fix our economy. It’s not just that, as Keynes said, “in the long run, we’ll all be dead.”

The reality is worse: In the long run, our lives (and the lives of generations unborn) will be poorer because we didn’t repair the economy as quickly as possible.

When Janet Yellen says the Fed has more work to do, this is what she means. It may not be too late to reverse the long-run damage to the economy’s potential. If we can bring back the unemployed before their skills erode completely... If we can encourage businesses to invest more now in the research and development that will bear fruit only in the distant future... If we can reverse the decline in productivity growth…

Everyone wants to know if Yellen is a hawk or a dove. The hawks on monetary policy only see one tail of risk: The risk that the Fed is blowing bubbles and fueling inflation down the road. The doves of monetary policy only see the other tail: The risk that high unemployment leaves permanent scars, not just on individuals but on society as well.

By that standard, Yellen is neither hawk nor dove. And no one else on the Fed is 100% one or the other. They all recognize the risk that easy money will lead to financial disaster if left in place too long, and they all recognize that unemployment is an immense human tragedy. They put different weights on those risks, but they all see them.

In some ways, Yellen has the perfect training to lead the Fed at this moment. In her professional life, she’s seen it all.

Her early academic career was dominated by trying to understand the human and institutional behaviors that fueled the great inflation of the 1970s. In the 1990s, she learned as a Fed policy maker that a high unemployment rate wasn’t necessary to keep inflation bottled up. In the 2000s, she saw how terribly destructive financial bubbles could be.

In all three eras, she realized that monetary policy makers needed to be flexible, open-minded and humble.

The Fed has three tasks: sustaining stable prices, maximum employment and a benign financial sector.

Frankly, it’s easier to juggle three chainsaws. Lucky for us, Yellen has seen what happens when you take your eye off one of the saws. Let us hope that no one loses a toe, or a hand, or a head during her tenure.

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